Taxation of resident aliens in the U.S.

by Smolowitz, Sidney

Abstract- Resident aliens are taxed under different rates than non-resident aliens, and they are taxed on their worldwide income. The Tax Reform Act of 1984 defined guidelines for defining resident aliens. Resident aliens must meet either the lawful permanent resident, or green card test or the substantial presence test. Nonresident aliens can elect to be treated as resident aliens if: they if do not have a green card or do not meet the substantial presence test in the year following election; are s present in the US for 31 consecutive days; and are present in the US for at least 75% of the days beginning the 31-day period to the end of the year. Resident aliens seeking to cease residence for tax purposes must prove a closer connection to a country other than the US and will be treated the same as US citizens expatriating themselves for tax avoidance if tax avoidance is the purpose of ending resident status.

Foreigners coming to the U.S. face complex rules both in determining
when they become U.S. residents and when their U.S. residence ceases.
The determination of residence is significant because resident aliens
are taxed under a different regime than nonresident aliens. Resident
aliens, like U.S. citizens, are taxed on their worldwide income, while
nonresident aliens are generally taxed at regular rates on income which
is effectively connected with a U.S. trade or business, and at a 30% (or
less, as provided by treaty) withholding rate, on dividends, interest
and other fixed or determinable periodic income. Before TRA 84

The term "residence" had been defined by Reg. 1.871- 2(b) before TRA
84, but there was no precision in defining whether an individual was a
resident or nonresident alien. The status of the taxpayer depended
largely on intent as to whether or not the individual was a transient.
Present Law

TRA 84 added Sec. 7701(b) to the IRC. It provides a specific
definition as to when an alien becomes a resident, stating that an
individual so qualifies when satisfying either:

1. The lawful permanent resident (green card) test; or

2. The substantial presence test. In addition, provision is made for
an alien to elect to be treated as a U.S. resident. Lawful Permanent
Resident

An alien is considered a resident alien after becoming a lawful
permanent resident. Such person is one who, under the immigration laws,
is granted the privilege of living permanently in the U.S. (i.e., the
individual is issued a green card). The individual generally continues
as a U.S. resident until the green card is abandoned or revoked under
the law. The lawful permanent residence test has nothing to do with the
number of days spent in the U.S. An alien is subject to U.S. tax as long
as the green card is retained, even if no time is spent in the U.S.
Substantial Presence Test

An alien satisfies the substantial presence test if present in the
U.S. for at least 183 days during the current calendar year, or under a
formula method is deemed to be present in the U.S. for 183 days in the
current year. Under the formula, each day in the current year is counted
as one day; each day in the first preceding year is counted as 1/3 of a
year; and each day in the second preceding year is counted as 1/6 of a
day. However, the individual must be present at least 31 days during the
current calendar year for the test to become effective even if the
numerical test under the formula is satisfied.

It is important to determine what constitutes a day of presence in
the U.S. Under the regulations an alien is considered to be present for
a day if physically present in the U.S. at any time during that day. The
Prop. Reg. Sec. 301.7701(b)-(3)(d) provides that days in transit between
two foreign points may be excluded where the individual is in transit
and physically present in the U.S. less than 24 hours. The regulations
caution that there can be no ulterior motive by the individual; if the
alien goes from one airport to another to change planes to a given
destination, the alien is then considered to be in transit. However, if
the alien attends a business meeting while in the U.S., even if still at
the airport, the alien is not considered to be in transit. The Prop.
Regs. do not, however, provide a realistic definition of what
constitutes a business meeting.

The regulations do not indicate the result when the alien telephoned
the home office from the airport and a conference call was arranged with
U.S. and foreign business associates. Is the alien treated as present in
the U.S. when in U.S. airspace, flying between two points to get to a
plane to leave the U.S., and accepts a business phone call? If the alien
is paged at a U.S. airport while waiting to make a flight out of the
country and receives a business phone call, will this business contact
be counted as a day of presence in the U.S.? Election to be Treated as a
U.S. Resident

A nonresident alien can, under Sec. 7701(b)(1)(A)(iii), make an
election to become a U.S. resident in the first year of presence where
the alien does not meet the substantial presence test. Prop. Reg.
301.7701(b)-4(c)(3)(iv) provides the requirements for electing to be
taxed as a U.S. resident. The individual:

1. Does not have a green card or does not meet the substantial
presence test with respect to the calendar (election) year, or the year
preceding the election year;

2. Meets the substantial presence test in the year following the
election year; and

3. Is both present in the U.S. for 31 consecutive days during the
election year, and is also present in the U.S. for at least 75% of the
number of days during the period that begins with the first day that
begins the 31-day period until the end of the year.

The purpose of the 75% test (item 3) apparently is to require a bona
fide period of U.S. residence, before giving an alien the right to elect
to become a U.S. resident. While it may be counterproductive to elect to
be taxed as a U.S. resident where gains are to be realized, this is not
the case where losses are incurred. Thus, it would often be desirable
for a nonresident alien (NRA) to elect to be subject to U.S. tax where
the alien can establish a capital loss carryforward which may be
available in subsequent years when required to file a resident U.S.
income tax return. In addition, deductions and exemptions available to
resident aliens are much more liberal than those available to NRAs.
Since the period required to establish U.S. residency is relatively
small, many planning opportunities may be available.

Congress, by specifically defining who is a resident alien by
statute, has added certainty to the law. One needs only to determine if
the person is a lawful permanent resident or meets the substantial
presence test under the statute. Terminating U.S. Residence

For illustrative purposes, assume "T") a British citizen, over 65
years of age, who has a green card and has been living in the U.S. for
many years with his wife, wishes to retire and move to the Bahamas. He
has certain attachments to the U.S.; he owns his own home, and his
children and grandchildren live in and are citizens of the U.S. His
largest unrealized security gain is in his employer's securities which
were acquired in the open market over a number of years; he expects that
his employer will soon be acquired. In addition, he also has a
substantial unrealized gain in a diversified portfolio of other
securities. Avoidance of U.S. tax on the appreciation of the securities
presents certain problems, particularly where he wants to retain certain
ties in the U.S. Resident alien "T" would like to be taxed as a NRA so
that he could avoid tax on the appreciation of his securities. NRAs are
taxed on their capital gains only when present in the U.S. for 183 days
or more under Sec. 871(a)(2). However, NRAs are taxed on the disposition
of stock of domestic corporations where U.S. real property interests
constitute at least 50% or more of the assets of the corporation without
regard to the number of days present in the U.S.

An individual can cease being a U.S. resident by giving up his
green card. For this recision to be effective under Sec. 7701(b)(2)(B),
there must be a formal proceeding before immigration authorities. If,
after having spent 183 days of a year in the U.S., "T" gives up his
green card and then sells his securities, he will be subject to tax as a
resident alien on his capital gains. Sec. 871(a)(2) exempts from tax
capital gains only of a NRA present in the U.S. for less than 1$3 days.
Even if "T" had spent less than 183 days in the U.S. before
surrendering his green card, he still may not be able to avoid the
capital gains tax on the disposition of the securities. This could occur
because "T" failed to meet the special requirements of the statute with
regard to termination in his final year of residence in the U.S. Last
Year of Residence

An alien, for tax purposes, may still be treated as a resident
alien in his or her last year of residence, even though the alien has
ceased U.S. residence. This situation applies if, during the balance of
the year in which leaving the U.S., the alien fails to have a closer
connection to a foreign country than to the U. S., or is a resident of
the U. S. at anytime during the next calendar year.

Sec. 7701(b)(2)(B)(ii) provides that during the balance of the year
in which "T" surrenders his green card, to avoid U.S. residency, he
must maintain a tax home in a foreign country and must have a closer
connection to that foreign country than to the U.S. Accordingly, in the
year of departure the alien, who has avoided the 183 day rule of Sec.
871(a)(2) but met the substantial presence test under the formula
method, can avoid the tax on capital gains in the year of departure by
having a closer connection to a foreign country than to the U.S. for the
balance of the year.

Apparently Congress was concerned that some longterm alien
residents may not really have severed their connections with the U.S. in
the year of departure. Presumably, they would realize a gain after
departing the U.S., which avoided U.S. tax, without having really
established a bona fide foreign residence outside the U.S. The closer
connection provision with a foreign country is designed to ensure that
there is a bona fide foreign residence in the year of departure from the
U.S.

In addition, Sec. 7701(b)(2)(B)(iii) provides that the departing
resident alien cannot be a U.S. resident at any time during the next
calendar year. Therefore, if "T" becomes a U.S. resident in the year
following his year of departure, he would be treated as a U.S. resident
for the preceding year as well, and his income, including capital gains,
would be subject to tax. Determination of Tax Home

An individual's tax home according to Prop. Reg. 301.7701(b)-(2)(c),
is considered to be at the regular or principal (if more than one
regular) place of business, or if the individual has no regular or
principal place because of the nature of the business), then at the
regular place of abode.

Reg. 1.911-2(b) provides that the term "tax home" has that same
meaning as for Sec. 162(a)(2) relating to travel expenses away from
home. Under the principles of Sec. 162(a)(2) dealing with business
deductions (and consequently for purposes of Sec. 7701(b)) an
individual's tax home is generally considered to be located at the
principal place of employment.

A close reading of the Prop. Reg. 301.7701(b)-2(c)(1) does not
appear to provide guidance for a retired person. It states that an
employed individual will have an opportunity to have a tax home at the
regular place of employment. Since a retiree has no job, his situation
does not appear to fall within the scope of the Regs. Hopefully, the
final regulation will address this situation, and provide guidance for a
retired person, leaving the U.S., who wishes to establish a tax home in
a foreign country. Prop. Reg. 301.7701(b)-(c)(2) provides that the
alien's foreign tax home must be in existence for the entire current
year." It appears that the regulation is improperly drafted since the
statute only requires "T" to have a closer connection to a foreign
country after abandoning the U.S. residence. When the Prop. Regs. are
finalized, they should specify that a U.S. person abandoning a residence
is only required to have a closer connection to a foreign country than
to the U.S. beginning with the period subsequent to the time of
abandoning the U.S. residence. Closer Connection Rules

Having established a foreign residence, the taxpayer must then prove
a closer connection to that foreign country than to the U.S. Prop. Reg.
301.7701(b)-(2)(d) furnishes a list of items (not all inclusive) which
may be used to determine whether "T" has a closer connection to a
foreign country than the U.S.:

1. The location of the individual's permanent home;

2. The location of the individual's family;

3. The location of personal belongings, such as automobiles,
furniture, clothing and jewelry owned by the individual and family;

4. The location of social, political, cultural or religious
organizations to which the individual has a current relationship;

5. The location of the individual's personal bank accounts;

6. The type of driver's license held by the individual;

7. The country of residence designated by the individual on forms
and documents;

8. The types of official forms and documents filed by the
individual, such as Form 1078 Certificate of Alien Claiming Residence
in the U.S.) or Form W9 (Payer's Request for Taxpayer Identification
Number); and

9. The location of the jurisdiction in which the individual votes.

These items apply a facts-and-circumstances test so that it appears
each case will be decided on its own facts, which will produce little
guidance for taxpayers and substantial litigation.

For the balance of the year after he leaves the U.S., "T" must
maintain a closer connection to the foreign country that he considers
his primary residence than the U.S. Two of the factors that will
prejudice "T's" position are that he is continuing to maintain his U.S.
residence and that his children and grandchildren are located (and are
citizens) in the U.S. In addition, it is expected that "T" and his wife
will come to the U.S. periodically for visits. These factors indicate
there is a strong tie to the U.S. Nevertheless, since his children are
not dependents and since "T" is establishing a bona fide foreign
residence and is living in a community (the Bahamas) with friends, (many
of whom, like "T", are British citizens) there is a strong likelihood
that his position as a NRA will be sustained.

There is one other thing that "T" can do to enhance his position
as a NRA in the year of departure. Reg. Sec. 3901.7701(b)-(2)(d),
describing the alien's home states:

"For the purpose of this paragraph, it is immaterial

whether a permanent home is a house, an apartment,

or a furnished room. It is also immaterial whether the

home is owned or rented by the alien individual. It is

material, however, that the dwelling be available at an

times, continuously, and not solely for stays of short

duration."

Based on this wording, it appears it can be applied to the U.S.
residence, as well as the foreign residence. Therefore, if "T" were to
rent his U.S. house for the period he does not intend to use it, his
stay would be limited to a short duration and would then appear to fall
within the precise meaning of the regulation, and he would not be deemed
to have a U.S. home. Substantial Presence Test

Even though "T" has properly surrendered his green card, he may
still be unable to avoid U. S. tax if he meets the substantial presence
test. Sec. 7701(b)(2)(B)(iii) provides that the individual is not
treated as a U.S. resident after he abandons his U.S. residence,
provided the individual is not a resident of the U.S. at any time during
the next calendar year. Thus, if "T" has spent, in the second preceding
year, 300 days in the U.S., and 240 days in the first preceding year, he
will have spent in that two year period (under the rules previously
described) a total of 150 days in the U.S. If he spends 33 days in the
U.S. in the current year, he would comply with the requirements of the
substantial presence test.

Sec. 7701(b)(3)(B) provides an exception to the above rule
pertaining to the substantial presence test. It provides that where an
alien is physically present in the U.S. for less than 183 days in the
current year, and though he meets the substantial presence test under
the formula method, if he has a tax home in a foreign country, and has a
closer connection to such a foreign country, he will not be deemed to be
a U.S. resident.

It would appear that an alien can spend up to 182 days a year in the
U.S. and fall within the substantial presence test yet avoid being
treated as U.S. resident, provided there is a closer connection to a
home in a foreign country. Limited Expatriation Rule

To forestall the possibility that resident aliens, after living in
the U.S. for an extended period would leave for a short time, become
NRAs, recognize a gain which would avoid U.S. tax and then return to
U.S. residency status, Congress enacted Sec. 7701(b)(10). That section
taxes an alien in a manner similar to that used by Sec. 877 to tax a
U.S. citizen who expatriates himself to avoid U.S. tax. One major
difference is that Sec. 877(b) only applies to a U.S. citizen where
there is intent to avoid tax. Sec. 7701(b)(10) provides a mechanical
test which becomes effective even where the alien inadvertently spends
more than 183 days in the U.S.

Sec. 7701(b)(10) provides that if an alien was treated as a U.S.
resident over a period that included parts of three consecutive calendar
years (which residency period can be as little as 14 months), stops
being a resident, and then becomes a U.S. resident again not having
allowed three complete calendar years to lapse before he resumes his
U.S. residency, he becomes subject to tax under 877(b). Sec. 877(b)
applies only if that tax exceeds the tax that would be imposed as a NRA
under Sec. 871. Sec. 871 taxes NRAs at 30% rate on their fixed
determinable U.S. source income and excludes capital gains from tax when
the NRA is present in the U.S. for less than 183 days.

Sec. 877(b) has as its objective the taxation of U.S. source income
that a resident alien believed could be avoided by giving up residence.
The statute accomplishes this by taxing nonresidents during the period
they were absent from the U.S. on: 1) their U.S. source income which is
effectively connected with U.S. trade or business; and 2) U.S. source
investment income as defined in the statute, which includes gains from
the sale of stock of U.S. corporations. The tax is imposed without
regard to the 183 day rule applicable to NRAs. The tax will be imposed
under the graduated rates of Sec. 1 of the code unless the alternative
minimum tax imposed by Sec. 55 applies.

It thus appears that unless "T" inadvertently becomes subject to the
Sec. 877(b) tax by becoming a U.S. resident (inadvertently meeting the
substantial presence test) he may be able to avoid tax on the sale of
his securities. To do it, he must set up his new residence in the
Bahamas, have a closer connection to the Bahamas than to the U.S., and
avoid the substantial presence test in the year after the year of
departure. Residence Gain

"T's" plan, as previously stated, is to move to the Bahamas, and
make his home there; to return to the U.S. in the summer months, visit
with his children and grandchildren; and continue to use his old home as
a residence when staying in the U.S. Under this scenario when "T", as
resident of the Bahamas, sells his U.S. home, he will be subject to tax
as a NRA, under Sec. 897, which taxes NRAs on the disposition of real
property interests. Sec. 1445 provides that the transferee (buyer) is
usually required to withhold 10% of the proceeds of the sale. Where the
selling price of the house is $300,000 or less and the buyer is going to
use the property as his residence, no withholding is required.
Nevertheless, the seller is still subject to tax under Sec. 897. Reg.
Sec. 1.897-6T(a)(5) provides that a NRA individual shall not be entitled
to nonrecognition of gain (Sec. 1034 deals with rollover gain on sale of
a residence) when he sells his U.S. residence and the new principal
residence acquired is not a U.S. real property interest. Accordingly,
when "T" sells his U.S. home, he will be subject to tax since he is a
NRA without regard to the number of days spent in the U.S. Under Sec.
897, gain on the sale of real estate by a nonresident alien is treated
as income effectively connected with U.S. trade or business.

However, if "T" were to retain his green card, and purchase a
Bahamas home as a principal residence, it appears he would continue to
be subject to U.S. tax, as a resident alien. Therefore, the rollover
provision of Sec. 1034 could apply to him if he sold his U.S. home
within the required statutory period. In actual fact because "T" wants
to retain his U.S. home to live there during the summer months, it
appears he will be subject to tax on the gain when he disposes of the
property as a NRA.

Much of Sec. 7701(b) is spent defining when a resident alien becomes
a NRA in terms of days. It would appear that maintenance of a principal
residence in the U.S. may be inconsistent with the taxation of that
NRA's home. Situations may occur where the IRS determines that an alien
is still a U.S. resident (e.g., he meets the substantial presence test).
If the sale of his residence would otherwise be subject to tax because
of NRA status, the alien may be able to assert that he is still a
resident and that the rollover provisions of Sec. 1034 apply. Estate Tax

Having extricated himself from U.S. income tax residency issues,
the NRA must determine taxation for estate tax purpose. Sec. 2106 taxes
NRAs' estates to the extent the property they own is situated in the
U.S. TAMRA 88 increased the rate of tax on the nonresident's U.S. estate
of those NRAs dying after November 10, 1986; their U.S. property will in
general, be taxed at the same rates as U.S. residents. Estates of NRAs
dying before November 10, 1986, had been subject to lower rates. Certain
deductions including losses, debts, taxes, etc., continue in part to
serve to reduce the gross estate of the nonresident in arriving at the
taxable estate.

In addition to the change in rates, TAMRA created a further major
change for the estates of resident aliens. Previously, the marital
deduction was available where the decedent was a resident alien. Sec.
2056(d) now provides that the marital deduction is not available where
the decedent's spouse is not a U.S. citizen. This change may have the
unforeseen effect of causing resident aliens to become NRAs. The marital
deduction will be allowed where the property is placed in a qualified
domestic trust. The purpose of this trust is to make certain the assets
are subject to estate tax when the wife dies or principal is distributed
during her lifetime. Residence for Estate Tax Purposes

The Estate Tax Reg. 20.0-1(b)(1) defines a resident decedent as a
"decedent who at the time of his death had his domicile in the U.S."
Estate Tax Reg. 20.0-1(b)(2) provides that a "nonresident decedent is a
decedent who at the time of his death had his domicile outside the U.S."

Domicile is a question of intent-it is the place the person regards
as home, the place to which he or she always intends to return. A person
can have many homes but only one domicile. Reg. 20.0-1(b)(1) states: "A
person acquires a domicile in a place by living there, for even a brief
period of time with no definite present intention of later removing
therefrom." It would appear domicile is an entirely different concept
for estate tax purposes than residence for income tax purposes. Whereas
TRA 84 laid down defined standards for the determination of residence
for income tax purposes, the rules pertaining to residence for the
estate tax purposes remained unchanged.

Accordingly, there is a conflict between the determination of
residence for income tax purposes and estate tax purposes. For income
tax purposes a NRA can avoid the substantial presence test by watching
the number of days (less than 183) spent in the U.S. Nevertheless, for
estate tax purposes, the determination of residence is a question of
intent. The courts will attempt to determine the intent of the decedent
by reviewing the underlying facts.

The following illustrates the issue with regard to "T" who is now
deceased, and whose family (children and grandchildren) reside in the
U.S. The decedent, prior to his death, visited his children and
grandchildren after having changed his status from a resident to a NRA.
By limiting his stay in the U.S., he was able to avoid the substantial
presence test for income tax purposes. Nevertheless, it is possible the
courts will take the position that for estate tax purposes the decedent
never abandoned his U.S. residence because his family remained in the
U.S. He had a closer nexus to the U.S. than any other country.

A more interesting question is presented where the decedent, a NRA,
spends less than 183 days in the U.S. each year over a number of years
but falls within the substantial presence test because of the formula
computation. However, the alien complies with the exception to the
substantial presence test under Prop. Reg. 301.7701(b)-2(d) by
maintaining a closer connection to a foreign country than to the U.S.
Will the alien be able to claim that the same rule should be applied for
estate tax purposes?

It is unlikely that the courts will abandon their analysis of the
facts, in determining a decedent's intent for establishing domicile for
estate tax purposes without a direct legislative mandate. Many items
listed in Prop. Reg. 301.7701(b)-2(d) dealing with the determination of
residence for income tax purposes are many of the same matters that will
be considered by the courts for determining residence for estate tax
purposes. Conclusion

There is no question that the definition in Sec. 7701(b) has added
a degree of precision to the determination of an alien's residency.
Hopefully, a similar rule or more precise definition will be provided
for estate tax purposes. It is possible that, because the definition of
residence for income tax is so precise, (and possibly easy to avoid),
nonresident aliens will be spending more time in the U. S. It is
therefore possible that they will be exposing themselves to estate tax
as resident aliens.

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